Over the last few years, there has been a rise in trading platforms that allow affordable access to financial markets for regular working people. Over the last year, many more people have joined these platforms to trade while furloughed or working from home. Trading stocks and bonds were once expensive and carried out through a third-party with large commissions, but the internet has made it possible to learn about what to buy and sell and then execute these trades with minimal costs.
However, this week, financial companies and independent traders had clashed when a hedge fund attempted to make a risky bet against an American high-street retailer. Melvin Capital decided that GameStop stock was overvalued and made an enormous bet that it would reduce in value. A group of individual traders on a Reddit subforum coordinated an effort to buy this stock, raising the price significantly and costing Melvin Capital billions of dollars.
It is not clear who the winners and losers are yet as Fidelity and BlackRock already owned large numbers of GameStop shares, other hedge funds also bet against the retailer and lost heavily. Additional funds will have profited in the chaos. What is clear is that government intervention into trading is likely to result from the situation. If they choose to protect the risk-taking financial institutions, this may hurt the recent increase in individuals accessing the stock market and encourage these financial institutions’ risk-taking.
A free market allows the voluntary exchange of goods and services, guided by supply and demand, without government intervention. People are free to trade with whoever and whenever they want and produce goods based on what people want to buy at a cost that allows them to make an income. In a real free market, government intervention is restricted to protecting personal property rights, upholding the rule of law, and maintaining the national currency’s value.
The current systems in most western countries, however, are not pure free-market systems. Governments intervene to regulate and provide insurance to prevent large adverse outcomes and maintain stability. They prevent individual companies in a market from becoming too big to promote innovation and competition. Governments also provide some public goods and services such as education, roads, a national military, and police. They redistribute wealth, and they correct for externalities that are not priced in production such as pollution.
Most people agree that a pure free-market system is not desirable. Some government intervention is positive, mainly to help those who find themselves in a negative situation for no fault of their own. For example, most western countries provided universal healthcare free at the point of use and paid for through general taxation. It is hard to argue against giving healthcare to people who needed it without the worry of direct costs; however, government involvement can produce a lack of competition, so the system’s quality and efficiency may suffer.
There is a lot of debate in politics about how much intervention is needed, and the negative consequences of a particular intervention are more significant than the benefits it brings. The promise of liberalism, according to The Economist newspaper that was set up to promote free-market ideas, is the commitment to individual dignity, open markets, limited government and a faith in human progress. However, the criticism of liberalism is that although it has been the most successful political approach in history, the benefits have been distributed unevenly. The uneven distribution and lack of dignity for many groups have led to significant government intervention in all areas of peoples lives, from increased regulation that limits freedom, restrictions on speech and so ideas, and taxation that creates distorted incentives and outcomes.
Much of this intervention has created positive outcomes, providing the promise of liberalism to a more significant number of people and balancing some of the inequalities created by a somewhat free market. A significant negative consequence, however, is that of moral hazard.
Moral Hazard: In economics, moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.Wikipedia
An oversimplified description of Moral hazard is enjoying the positive consequences of your actions while passing the adverse effects on others. This increased risk-taking level is not always deliberate, but the presence of insurance can lead to a flawed calculation of risks involved. It may also occur when the entity taking the risk understands the situation more than the entity paying the cost of the consequences or evaluating the risks being taken.
To use our previous example, some critics of universal healthcare argue that the state’s health insurance may encourage some people to be less concerned with their health and make poor decisions around diet, smoking, and excessive alcohol consumption. The same people make arguments about longterm welfare benefits making returning to work less attractive or financially rewarding, leading to a loss of purpose and dignity. Moral hazard can be seen in the workplace where people are rewarded through bonuses for successes but have no direct consequences for losses, leading to excessive risk-taking. At the national level, as we saw in the banking crisis in 2008, some financial companies take on very high levels of risk, profiting when it goes right and relying on government bailouts when it goes wrong.
Moral hazard and Melvin Capital
Both the US and UK financial regulatory agencies have commented about the instability caused by the Malvin Capital and Game Stop situation. Some financial leaders have uncharacteristically been calling for regulation to prevent the problem from happening again. What happens next with regulation is essential for delivering on the promise of liberalism to all and for moral hazard.
Will western governments live up to the liberal ideal and protect retail investors’ right to trade and benefit from markets or will they act on the side of risk-taking billionaire hedge funds reinforcing moral hazard and setting the economy up for even more significant problems in the future?
Regulators may move to restrict the way individuals are allowed to trade to protect the risk-taking of financial companies in the name of stability and protecting these individuals against themselves and the chance of losses if they bought GameStop the peak at $469.24 hoping to make money, but this misses the point. This action called the bluff of a hedge fund taking a risk that they believed no one would question. Regulators should continue to allow this type of activity that caused short term volatility for the long term stability it will bring.